The Domino Effect of Europe Bank Woes

Concerns over the health of European banks are rattling markets Thursday.

So it’s worth taking a closer look at which dominos are likely to start tumbling.

Investors are still quite spooked about the financial sector. When bad news about banks hits the headlines, there is a knee-jerk tendency to sell shares, redeem funds with exposure to the banks, and seek safe-haven.

Today’s Wall Street Journal story said that officials at the Federal Reservehave been in talks with the heads of European banks with U.S. businesses. This could be taken as a reassuring sign that regulators are proactively attempting to address potential problems. Lots of investors are probably going to take the most conservative view, however, viewing it as a sign of real problems.

This leads to selling, not just European bank shares, but U.S. bank shares. Why? Part of the reason is that we just don’t know how interconnected various financial institutions are with each other. But 2008 taught us that just because we don’t see the connections, it doesn’t mean they aren’t there.

There’s also the problem with hedge fundstrying to hedge exposure to European banks. The short-sellingban on European banks makes hedging exposure more difficult. One response by some hedge funds will be to short U.S. banks as a proxy.

Large depositors are also likely to flee, withdrawing money out of European banks and putting them in U.S. banks. There’s no evidence of anything like a bank run underway, though at the margin, it’s likely the European banks are seeing withdrawals.

Then we have the prime money-market funds. The yield on these funds is so small right now that some smart people on Wall Street wonder why anyone has money in them at all. If you are being paid 0.04 percent for any amount of risk, why not just stick it in a risk-free account, perhaps a money-market fund that owns only Treasury bonds, or just buy Treasury bonds directly.

Yet there still is a lot of money in prime funds. Some of that is likely to be withdrawn by investors concerned about the exposure of the funds to the financial sector. Money-market funds are ordinarily a big source of short-term funding for both U.S. and European banks with dollar obligations. So fears about Europe or the financial sector translate into redemptions at money-market funds.

Imagine for a moment that you are a corporate Treasurer at a company sitting on $100 million. The Wall Street Journal lands on your CFO's desk. Now he wants to know what the company's exposure to Europe is. Do you want to tell him you have tens of millions in funds that may be exposed to Europe, and that those millions are earning you pennies? Not if you want to keep your job.

So you do the rational thing. You redeem out of prime funds. You put the money in the bank. Or in government funds. Or maybe you go buy some Treasury bills.

The good news is that money-market funds have a lot of liquidity right now. The U.S. banking sector is so flush with cash that it doesn’t really need to borrow short term. And the funds have been decreasing their exposure to European banks.

In fact, there’s a bit of circularity to this. Money-market funds concerned about redemptions move to assets with very short durations in order to stay liquid. This drives up the funding costs of European banks, who decide to just run down their reserves at the Fed instead.

The running down of reserves worries investors with money in the prime funds, which leads to redemptions.

Fortunately, this is unlikely to become a death spiral. The liquidity positions of the prime funds are solid. The reserves of the banks are enormous. There’s a lot of room for a credit crunch to run behind the scenes before it actually threatens the health of any but the weakest financial institutions.